Dissecting Flow-induced Trading

Abstract

This paper dissects mutual fund heterogeneous capital flow-induced trading (HFIT) into two components: mechanical capital flow-induced trading (MFIT) and discretionary capital flow-induced trading (DFIT), and it addresses the relatively unexplored question of the price pressure effects of mutual fund flow-induced discretionary trading. I find that DFIT is strongly negatively correlated with MFIT and is, on average, three times as large in magnitude. MFIT and DFIT vary by stock and fund characteristics, and across economic periods in separate ways. Portfolio return analysis shows that MFIT captures the momentum and reversal effects of the widely used flow-induced trading measure (FIT) proposed by Lou (2012). However, these effects are observed only in low-DFIT stocks, while high-DFIT stocks exhibit return continuation without reversal. DFIT exerts price pressure on stocks and contains fundamental information, challenging the widely accepted view that mutual fund flow-induced trading is non-informative. Further analysis of the price impact of expected DFIT demonstrates predictability inflow-driven transactions and highlights opportunities to front-run anticipated discretionary flow-induced trades, contributing to the understanding of front-running strategies.

Keywords: Mutual Funds, Active Management, Capital flows, Price Pressure. JEL codes: G11, G12, G23